Switzerland: Initial Coin Offering And The Related Tax Consequences

Initial Coin Offering (ICO), also referred to as Token
Generating Event (TGE), is a new and, until now, loosely regulated
form of crowdfunding, which is mainly used by companies whose
business model is based on the blockchain technology. In the centre
of this new form of financing is Switzerland; in particular the
so-called Crypto Valley Zug. In addition to regulatory challenges,
aiming to limit the risk of fraud, a TGE also leads to new tax
related questions.

1. Introduction

During a Token Generating Event (hereafter TGE") startups
and established companies issue cryptocurrencies (hereafter
Tokens") which are based on the blockchain technology. The
raised proceeds will be used by the company to fund the announced
project. In contrast to collective debt raising, an initial public
offering, or the increase of the company's equity, raising
funds in the form of a TGE is hardly regulated. In addition, a TGE
can be structured in such way that the investors are not entitled
to ownership, profits, or participation rights. In the cases of the
TGEs we consulted, even the effective use of the funds raised for
the announced projects was contractually waived. Hence, the only
obligation of the issuer is to deliver the token.

The function and features of the issued token highly depend on
the nature of the project. Given that the funds raised during the
TGE are required to finance the project, the virtual currency does
not have an intrinsic value at the time of issuance. Only when the
project (in most cases a software application such as a platform)
has been successfully completed, the token becomes usable.
Depending on the number of tokens purchased, the subscribers are
entitled to use the developed service. Speculative investors, who
have no interest in the end-product, wager that the project will be
a great success. In such cases, the demand for the tokens will grow
strongly, leading to capital gains for the investors. Of course,
participating in a TGE can be lucrative not only for speculators,
but also for the future users of the developed solution since they
can pre-order the services at a lower price than what would need to
be paid in the future.

Until now there is neither prevailing legal practice nor
administrative guidelines on the tax treatment of TGEs. Therefore,
this article aims to be an attempt to situate this new form of
financing into the existing Swiss legal system. In many cases a
company disposes over its own inventory of cryptocurrencies after
the TGE. The potential tax consequences arising from holding tokens
after the TGE are presented in the second part of the article.
Financial regulatory aspects – which are very important when
conducting a TGE – are not subject of discussion in this
article.

2. Corporate law structuring

The first step for founders considering a TGE is to determine
the legal form of the issuing entity. This decision depends on the
particular case and affects significantly not only the taxation at
the time of the TGE but also the tax consequences in the following
periods. When making this decision, also corporate law aspects must
be considered carefully. Numerous TGEs in Switzerland are carried
out by a foundation (Stiftung) as the issuer of the tokens.
However, it is also possible – and in particular from a
longterm perspective more practical – to use a corporation as
the issuer of the tokens.

2.1 Foundation as issuer of the tokens

Using a foundation to carry out the issuance of a cryptocurrency
is not primarily driven by particular tax or regulatory motives. It
shall rather increase the investors' trust in the project and
the issued currency (Good Governance). This because the use of the
foundation's assets in conformity with the foundations
statutory purpose is monitored by the supervisory authority. The
supervision ensures that not only the financial interests of the
initiators of the project are in the foreground, but those of the
project itself. This helps to foster trust in the project and
ultimately increase the value of the issued currency and procure
additional funds.

The disadvantage of a foundation is that the dedicated assets
(consisting of the funds raised during the TGE and all later
receipts) may be used only in the context of the notarised purpose
of the foundation. If the objectives of the foundation change or if
new projects are intended to be launched, a time-consuming revision
of the deed of foundation is necessary to adjust the
foundation's purpose. It is therefore important to carefully
define the foundation's purpose in advance of the TGE.

If a foundation conducts the TGE, an operating company owned by
the project initiators is usually responsible for the operational
realization of the project. This operating company employs the
programmers and technicians. For the realization of the project a
service agreement is concluded between the two companies. The scope
of the service agreement must be consistent with the
foundation's statutory purpose.

2.2 Corporation as issuer of the tokens

A corporation as an issuer has several advantages over a
foundation: On the one hand, token sales revenues are not tied to a
specific purpose; on the other hand, tokens do not have to be
issued separately from the operational implementation of the
project. However, if it is intended to issue the tokens in
Switzerland, whereas the actual realization of the project should
take place in another country, an organizational separation can
still make sense.

3. Tax treatment of the TGE

3.1 Properties of the tokens as basis for tax appraisal

Decisive for the tax treatment of a TGE is primarily the
function of the issued tokens. Roughly speaking, a distinction can
be made between three different types of functions:

A Currency Token is a
digital currency, like bitcoin. Coding mechanisms determine the
denomination of the currency and enable the verification of
remittances.

In contrast a Utility Token
is a digital currency, which enables access to specific services or
platforms.

Tokenised Securities on the
other hand constitute rights against the issuer of the tokens or a
third party. These may be rights to assets or codetermination. From
an accounting perspective they may be equity or debt.

Most companies conducting TGEs in Switzerland have issued
Utility Tokens. For this reason, the Utility Token is given special
emphasis in this article. The regulatory requirements for such TGEs
are usually limited to compliance with KYC provisions in accordance
with the Federal Act for the Combating of Money Laundering and
Terrorist Financing. If other types of tokens are issued, more
complex regulatory issues arise.

For more detailed information regarding regulatory law please
refer to the "Guidelines for enquiries regarding the
regulatory framework for initial coin offerings (ICOs)"
published February 16, 2018 by the Swiss Financial Market
Supervisory Authority (FINMA).

3.2 Corporate income tax treatment of

Utility Tokens

The tax treatment of the TGE does not differ essentially whether
a corporation or a foundation carries out the TGE. However, on
federal level (and in most cases also on cantonal level) the tax
rate for foundations is lower than the rate applicable for
corporations. The effects on the income and expense side of the
profit and loss statement resulting from a TGE are reflected
hereinafter in separate subchapters.

As a result of this, the tax treatment of a TGE is highly
dependent from the provisions of the Swiss Commercial Law
("OR"). According to Art. 959b ff. OR the income
statement includes revenues from supplies and services, revenue
from other sources, and all operating and nonoperating
expenditures. "Revenues from supplies and services"
comprises all actual operating turnovers from the sale of products
produced or services rendered (MARKUS NEUHAUS/JÖRG
BLÄTTLER, in: Honsel/Vogt/Watter (Hrsg.), Kommentar zum
Obligationenrecht II, Art. 663 OR N 14). In most cases the company
receives a cash payment for the sold supplies and services.
However, it is also possible that other goods or services are
received in consideration for the company's goods or services
(barter). If this is the case, the market value of the received
consideration is relevant for accounting purposes (BGer dated 13
February 2008 2C_506/2007).

It can therefore be concluded that the sale of Utility Tokens
– where the receipt of the funds results neither in an
interest in the company nor in a debt liability – is to be
captured as proceeds from supplies and services. Therefore, also
from a tax perspective, the funds collected simply reflect the
purchase price for the sale of a defined quantity of tokens. In
most cases, the purchase price is paid in Ether, Bitcoin or another
cryptocurrency. The amount of income depends on the units of
cryptocurrencies received and the prevailing exchange rate.

As mentioned initially, the tokens issued are intended to enable
access to specific service or platform. As the development of the
service or platform is financed with the funds from the TGE, the
issued currency cannot be used for the intended purpose yet. The
sale of Utility Tokens is therefore to some extent a prepayment
(without having the right of a repayment).

b) Expenses and costs of a TGE

In general proceeds from supplies and services are (at least
partially) offset by costs of raw material, goods and employees and
other expenditures incurred for the purchase or production of the
products and services sold.

In the case of prepaid purchases, long-term project financing,
or production orders, the rendering of the services and the payment
of the consideration do not accrue at the same time. The principle
of accrual accounting under Art. 958b Para. 1 OR requires that
income and expenses, which arise in a period, are also accrued and
recognised accordingly. Moreover, a correct accrual of expenses
(i.e. full recognition of liabilities, accrued costs and reserves)
is of significant importance in order to safeguard the principle of
prudence and imparity as to Art. 960a OR. Based on the imparity
principle, income is realised when a legally and effectively
enforceable claim has arisen. On the other hand, expenses are
already recognised when losses or risks are probable and
recognisable from the transactions prior to the closing date (cf.
HWP Band 1, I.2.3, S 8).

Since the project to be realized is still largely to be created
at the time of the TGE, the generated income from the token
issuance should (at least partially) be offset by the future
operating expenses that are necessary to make the token ready for
use. Therefore, at the point when the revenues are recognised as
income, the future development and operational costs must be
accrued as a provision, to ensure that the associated income and
expense are recognised periodically. Hence, the provision makes
sure that the net profit/loss of the period is determined in
accordance with the applicable accounting principles.

Based on the rather restrictive tax rules for provisions (Art.
63 DBG), we recommend in any case filing an advanced ruling with
the competent cantonal tax authorities. In our experience, such
ruling can be successfully agreed if the project description, the
project costs, and the defined milestones are set out in detail.
Provided that the funds received from the TGE are equal to the
expected costs of the development of the project, no tax
consequences arise from the TGE. If however, the receipts from the
TGE exceed the expected costs, the resulting profit is subject to
tax.

In the following periods the recorded provision can be
continuously released by the expenses incurred for the development
of the platform or service. If the operational activities are
performed by a company other than the one that carried out the TGE
(cf. the abovementioned foundation model), the expenses incurred
are mainly related to the service fee remitted to the operating
company. Such a fee would of course have to be at arm's length.
In accordance with Art. 63 Para. 2 DBG the provision must be
released at the end of the period, in which the development is
completed. It must also be released, if the project is prematurely
terminated.

3.3 VAT treatment of the issue of Utility
Tokens

Any service rendered by a taxpayer against consideration is
subject to VAT, unless the Swiss VAT Law ("MWSTG")
provides for an exemption (Art. 18 Para. 1 MWSTG).

If a company receives funds without having rendered a service or
delivered a product, no commercial relationship exists. Such funds
(socalled «nonconsiderations») are therefore not
subject to VAT (Art. 18 Para. 2 MWSTG). A service or product sale
within the meaning of the Swiss VAT Law is the granting of a usable
economic value to a recipient in expectation of a consideration.
Usable economic values are goods and services which in any form
serve to satisfy a need or demand. Not usable in the sense of the
Swiss VAT Law are, for example, land and capital (money) (cf.
Botschaft zur Vereinfachung der Mehrwertsteuer dated 25 June 2008,
S. 6940).

The tokens issued during a TGE are digital means of payments,
i.e. a balance with the possibility of making a sort of payment in
electronic form in order to receive a certain consideration. In
contrast to the consideration to be received, the tokens as such
have no intrinsic value.

When one means of payment is exchanged for another means of
payment there is a lack of granting a usable economic value.
Therefore, no service or sale in the sense of the Swiss VAT Law is
given. Based on this the issuance of tokens is to be qualified as a
nonconsideration in the sense of Art. 18 Para. 2 MWSTG and is
therefore not subject to VAT. VAT consequences do, however, arise,
when the tokens are effectively used to obtain access to the
platform or service. At this point the question arises as to how
the consideration subject to VAT is to be determined in CHF.

If the tokens do not qualify as digital means of payments than
VAT consequences can arise, if there is no other exemption
applicable. If the token qualifies as a security token the issuance
of the token might fall under the exemption of Art. 21 Abs. 2 Ziff.
19 lit. e MWSTG (issuance of securities).

4. Possible tax consequences of holding cryptocurrencies

As stated above, after the TGE, the development of the announced
project is in the foreground. The incurred expenditures in the form
of direct costs and overheads are continuously reducing the
recorded provision. As soon as the development phase has been
completed, any remaining balance of the provision must in principle
be released and is subject to tax.

In addition to this, the taxation of the company's own
inventory of cryptocurrencies plays a key role for a company
performing a TGE. This is because the payments for the token sale
are in most cases received in other cryptocurrencies, such as
Bitcoin or Ether, and because the company does frequently not sell
all of the issued tokens during the TGE but also keeps a fraction
of the tokens created for its own stock. The tokens not sold are
often sold or assigned to various stakeholders such as employees,
founders, major investors or advisers at a later point in time.

Hereinafter the tax treatment of the token inventory will be
analysed in detail. As it is also the case for the taxation of the
TGE, the tax consequences arising from holding cryptocurrency
depends again on the applicable commercial law provisions and the
specific functions of the currency. Regarding the VAT consequences
on the sale of the inventory of cryptocurrencies please refer to
the preceding section.

4.1 General commercial law classification of
cryptocurrencies

Until now the legislator has not commented on the commercial law
treatment of cryptocurrencies held by companies. However, recently,
the professional organisation EXPERTsuisse has updated its Q&A
Document, Ausgewählte Fragen und Antworten zum neuen
Rechnungslegungsrecht" and addressed the question whether and
how cryptocurrencies – in particular Bitcoin – are to
be accounted for in the statutory accounts. The professional
organisation affirms that Bitcoin is capable for accountability in
accordance with Art. 959 Para. 2 OR. This is because the following
conditions are satisfied: disposability, probable inflow of funds
and reliable estimation of the value. In addition, they addressed
the question of how Bitcoin should be recognised in the balance
sheet (i.e. cash and cash equivalents, securities, inventories,
etc.).

For the classification as cash or cash equivalent it is
implicitly required that the currency qualifies as a legal
currency. Bitcoin does not satisfy this requirement. In addition
the volatility of Bitcoin is very high and the general acceptance
as a means of payment is lacking, so that important economic
properties of a currency are currently not given. The Swiss Federal
Council concluded the same in its report on virtual currencies
dated 25 June 2014 (cf. Section 2.2.1). The Council argued that due
to the high volatility, Bitcoin does not fully satisfy the basic
functions of money (means of exchange, accounting unit and means of
storing value). Therefore, Bitcoin is not to be classified as a
currency, but as an asset.

According to EXPERTsuisse, Bitcoin is to be qualified either as
securities (current or fixed assets) or as inventories. The former
is indicated, if holding of Bitcoin does not accord with the
company's ordinary business. If in the course of its ordinary
business a company continuously and to a significant extent trades
Bitcoin, a classification as inventories may be appropriate. In the
author's view this commercial law qualification applies also
for other cryptocurrencies, if the basic conditions of Art. 959
Para. 2 OR are met.

4.2 Tax treatment of the inventory of cryptocurrencies

a) Inventory of Bitcoin and other cryptocurrencies

Based on the above, Bitcoin, Ether or other cryptocurrencies,
which the company holds after the TGE, are not to be accounted for
as cash or cash equivalents, but either as securities or
inventories. This is because they do not satisfy the requirements
for qualification as a means of payment (see above).

The cryptocurrencies received by the company are recognised at
the value on the day of the inflow. The applicable exchange rate in
CHF is decisive for the initial recognition as income. As the
exchange rates for cryptocurrencies vary depending on the trading
platform, it is appropriate that the company relies on an average
rate of as many trading platforms as possible for determining the
applicable exchange rate. According to Art. 960a Para. 2 OR the
valuation of the inventory for subsequent years must be in
accordance with the historical cost principle (i.e. valuation
cannot be above historical cost). An exemption of this principle is
possible for assets which are publicly traded or that have an
observable market price. On the basis of this (optional) provision,
a company can value its inventory of cryptocurrencies at market
prices. In such cases the company can record a fluctuation
provision which is in line with the changing value of the
inventory. This gives the possibility to offset and defer any
gain/loss resulting from price movements of the inventory until the
gain or loss is actually realized.

If at a later date the inventory of cryptocurrencies is sold,
the company realises a taxable gain or loss in the amount of the
difference between the book value and the actual sales price. At
this time the fluctuation provision, if any, must be released.

b) Inventory of own tokens

The issued tokens are mostly based on socalled Smart Contract.
Expenses incurred for the programming of these Smart Contracts
constitute in principle production costs of the tokens. These
production costs are relevant for the initial recognition of the
issued tokens as inventory.

The tokens, which are sold during the TGE, reduce the inventory.
At the same time the payment, which in most cases is received in
other cryptocurrencies, is recognised as income at the prevailing
exchange rate. The difference between the production costs and the
corresponding inflow reflects the income arising from the TGE.

As stated above, the book value of the inventory of the tokens
equals the historic production cost. For the valuation of the
inventory in subsequent years, the same principles as mentioned in
the previous chapter are valid (i.e. historical cost principle with
the option to value the inventory at market prices if such prices
are observable).

If at a later point in time the retained tokens are sold, the
company realises taxable income in the amount of the difference
between the book value and the sales price. On the date of sale a
fluctuation provision, if any, is to be released.

5. Conclusion

Conducting a TGE is a challenge not only from regulatory
perspective, but also from a tax standpoint. As there are no
specific legal provisions or published administrative guidelines to
provide guidance, it is recommended that an advance ruling is filed
with the competent tax authorities.

The aim of the ruling is to ensure that in the tax period of the
TGE, a provision for the financing of the project can be set
against the taxable revenues received from the token sale. The
detailed description of the purpose of the business is of utmost
importance to successfully obtain a ruling. Particular attention is
to be accorded to the project description, the project costs and
the defined milestones. The latter is crucial for the tax
authorities in order to estimate the time when the project will be
completed. Surprisingly, most of the TGE in Switzerland were
performed without filing a tax ruling. In doing so many companies
have exposed themselves to great legal uncertainty.

Without a tax ruling, a provision claimed in the financial
statements will be reviewed by the tax commissionaire during the
assessment procedure. The company will then be required to provide
evidence that the provision was justified from a commercial law and
tax perspective. This gives the tax authorities a wide range for
action. Given the fact that the tax justification of a provision
can be disputed, the taxation of the TGE remains afflicted with
uncertainties, for which those involved could pay a high price.
Furthermore, it is important to remember that the climate in the
cryptoscene and the approach of the authorities may change one day.
For example, it is possible that the cantons or even the Swiss
federal tax administration may establish a practice, under which at
least some of the revenues would have to be taxed in the tax period
of the TGE (regardless of the expected cost for the development of
the project).

For example it might be possible that stricter rules could apply
to cases where the projects are developed and operated in foreign
countries. This is because a provision in the amount of the
received proceeds during the TGE could result in no Swiss taxes at
all, if the entity responsible for the development of the project
is located abroad.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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